Amortizing Bond Premium with the Effective Interest Rate Method

When a bond is sold at a premium, the amount of the bond premium must be
amortized to interest expense over the life of the bond. In other words,
the credit balance in the account Premium on Bonds Payable must be moved
to the account Interest Expense thereby reducing interest expense in each
of the accounting periods that the bond is outstanding.

The preferred method for amortizing the bond premium is the effective
interest rate method or the effective interest method. Under the effective
interest rate method the amount of interest expense in a given year will
correlate with the amount of the bond's book value. This means that
when a bond's book value decreases, the amount of interest expense
will decrease. In short, the effective interest rate method is more logical
than the straight-line method of amortizing bond premium.

Before we demonstrate the effective interest rate method for amortizing the
bond premium pertaining to a 5-year 9% $100,000 bond issued in an 8% market
for $104,100 on January 1, 2012, let's outline a few concepts:

The bond premium of $4,100 must be amortized to Interest Expense over
the life of the bond. This amortization will cause the bond's book
value to decrease from $104,100 on January 1, 2013 to $100,000 just
prior to the bond maturing on December 31, 2017.

The corporation must make an interest payment of $4,500 ($100,000 x 9% x 6/12)
on each June 30 and December 31. This means that the Cash account will be
credited for $4,500 on each interest payment date.

The effective interest rate method uses the market interest rate at
the time that the bond was issued. In our example, the market interest
rate on January 1, 2013 was 4% per semiannual period for 10 semiannual periods.

The effective interest rate is multiplied times the bond's book
value at the start of the accounting period to arrive at each
period's interest expense.

The difference between Item 2 and Item 4 is the amount of amortization.

The following table illustrates the effective interest rate method of amortizing
the $4,100 premium on a corporation's bonds payable:

Please make note of the following points:

Column B shows the interest payments required in the bond
contract: The bond's stated rate of 9% per year divided
by two semiannual periods = 4.5% per semiannual period
times the face amount of the bond

Column C shows the interest expense. This calculation uses the
market interest rate at the time the bond was issued: The
market rate of 8% per year divided by two semiannual
periods = 4% semiannually.

The interest expense in column C is the product of the 4% market
interest rate per semiannual period times the book value of the
bond at the start of the semiannual period. Notice how the interest
expense is decreasing with the decrease in the book value in
column G. This correlation between the interest expense and
the bond's book value makes the effective interest rate
method the preferred method.

Because the present value factors that we used were rounded to three decimal
places, our calculations are not as precise as the amounts determined by use
of computer software, a financial calculator, or factors with more decimal
places. As a result, the amounts in year 2017 required a small adjustment.

If the company issues only annual financial statements and its accounting
year ends on December 31, the amortization of the bond premium can be
recorded at the interest payment dates by using the amounts from
the schedule above. In our example there was no accrued interest at
the issue date of the bonds and there is no accrued interest at the
end of each accounting year because the bonds pay interest on June 30
and December 31. The entries for 2013, including the entry to record
the bond issuance, are:

The journal entries for the year 2014 are:

The journal entries for 2015, 2016, and 2017 will also be taken from the schedule above.

Comparison of Amortization Methods

Below is a comparison of the amount of interest expense reported under
the effective interest rate method and the straight-line method.
Note that under the effective interest rate method the interest expense
for each year is decreasing as the book value of the bond decreases.
Under the straight-line method the interest expense remains at a
constant annual amount even though the book value of the bond is
decreasing. The accounting profession prefers the effective interest
rate method, but allows the straight-line method when the amount of
bond premium is not significant.

Notice that under both methods of amortization, the book value at the time the bonds
were issued ($104,100) moves toward the bond's maturity value of $100,000.
The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond.

Also notice that under both methods the corporation's total interest expense over
the life of the bond will be $40,900 ($45,000 of interest payments minus the $4,100
of premium received from the purchasers of the bond when it was issued.)

About the Author

After working as an accountant, consultant, and university accounting instructor for more
than 25 years, Harold Averkamp formed AccountingCoach in 2003. His goal was to
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